Trade gap tugs dollar lower vs. euro

Forecast for U.S. interest-rate hikes underpin greenback

CBSMarketWatch

CHICAGO (CBS.MW) - The dollar fell from three-week euro highs Monday as a record-wide U.S. trade gap raised some worries over the longer-term health of the greenback.

The U.S. currency was down 0.5 percent against Europe's shared currency, at $1.2063 per euro, in late U.S. trading.

The dollar rose against the Japanese yen, holding a gain of 1 percent or more for much of U.S. trading and hitting its highest level in more than two weeks on prospects for rising U.S. interest rates. Higher rates would make dollar-denominated investments more attractive to foreigners and may help offset the impact from the huge U.S. trade deficit on the dollar.

The greenback was up 1 percent against the Japanese yen, at 111.14 yen late in New York's foreign-exchange session. The dollar was as high as 111.49 yen earlier, with traders taking their initial cue from a drop in Tokyo stocks on Monday. The dollar rose 0.3 percent against the British pound at $1.8133 and was down 0.3 percent against its Swiss counterpart, at 1.2552 francs per dollar.

The U.S. trade deficit widened by 3.8 percent in April to a record $48.3 billion, the Commerce Department said. Wall Street economists had forecast that the deficit would narrow to $45.1 billion. See Economic Report.

The gaping U.S. trade imbalance has hounded the dollar for more than a year. The dollar is pressured by uncertainty that the United States -- which offers international investors four-decade-low interest rates -- will be able to draw enough foreign capital to finance this gap in goods and services trade. A negative trade balance can also cut into GDP growth, further reducing the appeal of owning dollar-based assets.

Earlier, the dollar was at its best euro level in three weeks, sending the common currency below the key $1.20-area. Some analysts simply chalked up Monday's trading to a squaring of positions ahead of U.S. currency flow data and the U.S. consumer price index report, both due on Tuesday. See Economic Preview.

The day's other U.S. economic report was seen supporting ideas for an interest-rate hike later this month.

Boosted by higher sales of gasoline and autos, U.S. retail sales jumped 1.2 percent in May after dropping in April, the Commerce Department estimated Monday. See Economic Report.

Recent speeches from U.S. Fed officials, in which central bankers hinted at rising interest rates, helped the U.S. currency to an early lead against its major rivals and continue to underpin the dollar.

Minneapolis Fed President Gary Stern said Sunday that the central bank has a responsibility to keep inflation out of the economy. His comments largely echo those of other Fed members, including Fed Chairman Alan Greenspan, who said last week that his panel might have to be prepared to respond aggressively to changing economic conditions.

"A series of comments last week by Federal Reserve bank presidents warning to combat inflation spurred expectations of higher U.S. interest rates," said Kikuko Takeda, currency analyst at Bank of Tokyo-Mitsubishi. "The market's focus has changed from trying to predict how measured a pace the Fed's rate hike will be, to how boldly the Fed will raises rates."

"After learning a lesson in 1994, the Fed would probably want to avoid the confusion in the bond market as much as possible," Takeda said, referring to a period when abrupt rate hikes launched shock waves through financial markets.

U.S. financial markets now expect the Fed to boost its federal funds overnight rate by a full percentage point to 2 percent over the next three meetings.

The fed funds futures market at the Chicago Board of Trade is fully pricing in two quarter-point rate hikes and at least one half-point rate at the June, August and September meetings.

The fed funds rate will likely rise to 2.5 percent from 1 percent by the end of the year, according to the futures trading. A week ago, the market was predicting the fed funds rate would be 2.25 percent at the end of the year.

Politics weaken pound

The British pound was weaker against the dollar on Monday after European voters over the weekend handed incumbent political parties a big defeat. The euro fell against the dollar in sympathy with the pound initially, but turned firmer as U.S. trading began.

Political uncertainty can make the home currency unattractive to foreign investors. The pound has shed around 2 percent against the dollar since Thursday, when local elections in England and Wales also began.

"The data on the U.K. economy has been robust; this move is a bit more political than anything fundamental in the economy," said Gary Noone, analyst at Informa, in London. The Bank of England Thursday raised its benchmark interest rate by a quarter point to 4.50 percent, which presumably would stir interest in buying pounds.

Labour's defeats in the local elections and the European elections were expected. However, the results raise some uncertainty, Noone said. The U.K. Independent Party, which calls for Britain to withdraw from the European Union, was projected to place third with 16.8 percent of the vote, according to the BBC.

The Conservatives were leading with 27 percent of the vote; Labour was down 6 points to 23 percent. The result so far puts Labour at its worst showing for vote share since before the First World War, the BBC said.

Blair is still widely expected to lead Labour in the next general election, likely next spring. In the euro MP poll, the ruling French and German parties also saw setbacks.

"While it is not abnormal for governments to be 'unpopular' and suffer defeats in the midst of their parliamentary terms, the depth of unpopularity seems to have been greater since EMU began," Bear Stearns currency analysts said.

"We doubt that the poll results will have a huge bearing on the currency market. For choice, we would argue that they are slightly negative for the euro against both the dollar and the pound," the analysts added.

Tokyo stocks decline

Relatively weak Japanese shares also underpinned the dollar against the yen. The Nikkei Average ended down 0.3 percent in Tokyo. See Asia Markets.

The Bank of Japan began a two-day policy-setting meeting Monday. No change in monetary policy is expected, despite soaring long-term interest rates.

The yield on the 10-year Japanese government bonds (JGBs) rose for the eighth straight session Monday, topping 1.8 percent against the backdrop of Japan's strengthening economy.

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